Inflation and Human Nature

"...Scrabbling in the earth for a fresh source of cash, the gold & silver
miners of 13th century Europe proved that the money supply never simply increases
as if by magic..."

YOU MIGHT THINK Ben Bernanke's way with words mere cant, just so much
sophistry learnt from the Maestro.

But words matter when we're talking about inflation - or denying it. Choosing
the mot juste can prove as crucial as selecting (or denying) the right
data.

At the turn of the 20th century, for example, a German scholar, Wilhelm Abel,
noticed how medieval chroniclers writing nearly seven centuries earlier had
made a curious shift in their choice of words to describe rising grain prices.

Over the three decades between A.D. 1230 and 1260, wheat prices rose by about
one quarter in Italy, one-third in France, and nearly as much in England. Writing
about these increases year-by-year, Abel found, the chroniclers slowly switched
from blaming fames - or shortages and famines - to blaming caristia,
a word derived from carus, meaning costly or dear.

The middle of the 13th century, in other words, saw a switch in how people
described what was happening to grain prices. The cost of living - as measured
by the cost of having enough to eat - was no longer related to good or bad
harvests, not according to the chroniclers' choice of words. Instead, the cost
of living had become dearer. That changed the way people thought about prices.
It also changed the way they responded to rising prices, too.

General price levels kept growing more costly for the next century, in fact,
in a phenomena identified by David Hackett Fischer as the Medieval Price Revolution.

"People responded to the discovery of caristia [costliness] by deliberately
expanding the quantity of money," writes Hackett Fischer in his tome, The
Great Wave (OUP, 1996). "During the thirteenth century, a major effort
was made to expand the supply of silver in Europe. Old mines opened again in
Hungary...New mines were brought into operation. Output was increased by new
technology."

Scrabbling in the earth to uncover fresh supplies of money proved that extra
cash didn't simply appear out of thin air, as if by magic. It "was not a deus
ex machina," writes Hackett Fischer, "that descended inexorably upon the
economy. It was an artifact of human will and purpose."

Put another way, "the most important thing to remember," as Ludwig von Mises
reminds us, "is that inflation is not an act of God, that inflation is not
a catastrophe of the elements or a disease that comes like the plague. Inflation
is a policy."

Who's making policy today? Let's agree that semantics do matter; let's also
imagine for a moment that the word "inflation" only describes an increase in
the money supply. Then let's bend an ear to the latest choice of words.

"Inflationary pressures have been a feature of the major industrial economies
in recent times," said Gordon Brown, the UK finance minister this week.

"Inflation has risen not just in this country but in most of the major countries," said
his political partner and rival, Tony Blair - the UK prime minister - earlier
this year.

"Inflation rates have been pushed upwards across oil-importing countries," noted
José Manuel González-Páramo, an executive of the European
Central Bank (ECB) at a seminar in Helsinki last month.

"How should central banks react?" asked the ECB man. And what about the rest
of us?

The same pattern that Hackett Fischer found in the Medieval Price Revolution
of the 13th century - a pattern of higher price levels preceding a determined
attempt to increase the money supply - was also identified in the Price Revolutions
of the 16th and then 18th centuries. Steadily rising prices for basic foodstuffs
are recorded long before new sources of gold and silver were first tapped.

The Price Revolution of the 16th century, says Hackett Fischer's research,
actually began as early as 1480 - "many years before American silver and gold
arrived in Europe. In England and Germany, prices nearly doubled during the
half century before American silver could have had a significant effect on
their economies."

Whatever the initial cause of rising prices - and Hackett Fischer cites population
growth in all four of the Price Revolutions he identified between the 13th
and 20th centuries - observing the age-old response of human nature to higher
prices reveals the true problem of modern central banking. For both the policy
wonks themselves and for anyone trying to invest profitably under their fiat
money dominion, the natural response to rising prices is actually a search
for fresh supplies of cash.

Older, more studied and apparently wiser today, mankind of course knows to
meet higher prices with higher interest rates instead. Pace this week's
mini-China shock to the Shenzen and global stock markets, tighter reserve ratios
are also expected in the commercial banking sector. That should decrease the
multiplier effect, or so theory says, thus reducing the availability and growth
of credit.

When rising prices become clear in the data, rising interest rates are sure
to follow. The supply of money must be restricted, not increased.

But that's not quite what happens.

In the compact and compressed little Price Revolution we've experienced so
far in the 21st century, global interest rates slowly began turning higher
in late 2003. The Bank of England moved first, followed a year later by the
Fed...then the ECB in Frankfurt...and finally the Swiss National Bank and the
zero-rate crazy Bank of Japan. Yet the global money supply has by no measure
decreased.

The broad supply of Sterling has risen at a double-digit rate annually for
the past two years; M3 in the United States is now estimated by John Williams' ShadowStats to
be growing at nearly 12% year on year; Eurozone money supply is growing at
10% per year, the fastest rate since 1990.

Let's give the Fed, ECB and Bank of England their heads, and imagine that
they actually want rising rates to counter rising prices by restricting
money-supply growth. It simply hasn't worked over the last 12 months and more.

Could it be - shhhhhh - that modern central banking is impotent in the face
of a genuine and sustained rise in living costs? Are the wonks undone by the
rest of us - and most especially the commercial banks - scrabbling in the dirt
for fresh supplies of money to overcome the loss of purchasing power that higher
prices produce? Or will it take a surprise and shocking increase in interest
rates, a hike up to double-digits throughout the industrialized world, to cut
money supply growth and so cut the rate of inflation in prices?

"In cultural terms," writes Hackett Fischer of the 13th century gold and silver
seekers, "their actions helped individuals and institutions to cope with high
prices, but had the collective effect of driving prices higher."

High prices demanded more money; more money led to increased prices. If you
ever thought today's rising cost of living would somehow slow down by itself,
you failed to account for human nature.

Formerly City correspondent for The Daily Reckoning in London and head of
editorial at the UK's leading financial advisory for private investors, Adrian
Ash is the head of research at BullionVault,
where you can buy gold
today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

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